The Correct Call has been trying to get its head wrapped around this subprime tsunami. In this political season and all the finger pointing that comes with it, we are trying help our readers separate myth from reality and shed some light, as we understand it, on how we got here.
The Butterfly Flaps Her Wings:
Subprime loans were born of the Community Reinvestment Act (CRA) of 1977. They were originated to help high credit risk home buyers get loans. The 1986 tax reform act eliminated deductions on auto and consumer loans making home loans more attractive to borrowers. This marked the start of home owners using their home’s equity as currency. As interest rates rose during the early 90s, competition for dwindling prime loan applications squeezed profit margins and subprime loans became more popular and profitable for lending institutions.
Some say the repeal of the Glass-Stegall Act, combined with adding more muscle to the CRA, exasperated the problem as for the first time since the depression, banks and brokers were allowed to function as one. The repeal also encouraged banks to further liberalize their lending standards as all mergers would be based on the institution’s CRA score.
Then 9-11 happened. Alan Greenspan and the fed decided the best course of action was lower interest rates and flood the markets with money. The fed probably didn’t have a choice, but it made money essentially free to loan. And loan it they did in all kinds of innovated ways: interest only, you pick the payment, 40-50 year loans… they couldn’t give the money away fast enough. Tons of money pouring into real estate and investors flipping houses like day trades leads to artificially enhanced demand for homes, apartments, condos, commercial real estate… economics 101: Big demand, limited supply, huge price increases.
All the while these risky loans are being securitized and sold to institutional investors at all time highs. The credit agencies are rating these loans as investment grade and owners of the debt are borrowing against the supposed value of these collateralized mortgage obligations. This is all well and good as long as housing prices continue to rise. Pop goes the speculative housing bubble.
Meet one of the byproducts of Sarbanes-Oxley, mark to market. It’s an accounting term that means when investment firms do their reviews, they need to value their portfolios at the prevailing market price. For example, 1 million shares of a stock at $8 would equal $8 million for the quarter. If the stock is worth $6 at the time of the next accounting, then it’s put on the books for $6 million and so on.
For stocks, mutual funds, real property, bonds etc. this is easy because there is a market to base the underlying prices on. For securitized subprime loans, there was no market. Nobody had any idea of what they were worth. When the real estate market went south and delinquencies started rise, no one wanted these thing. So for accounting purposes, they were essentially worthless. Mark to market means companies had to put a big fat zero on that ledger line; hence all the massive write-offs. Since Freddie and Fannie held the most of these investments, it was bye-bye!
Remember we said companies were borrowing money against these loans? Think of it as a margin call. In order to meet their capital requirements, companies had to sell their good assets to create cash. So everybody is selling their good portfolio holdings to meet the calls for cash and guess what, the stock market goes down. No surprise her:. Economics 101, a ton of supply, limited demand, say hello to Dow 10,500.
On top of that, the credit agencies decide, well maybe these mortgage portfolios of subprime loans aren’t investment grade after all. Let’s downgrade them to junk. AIG had created an entire subset of insurance policies to back up these mortgage products based on the agencies’ credit ratings. The downgrades meant AIG would have to find $250 BILLION literally overnight. That wasn’t happening. AIG would have been vaporized and all the insurance products would have gone with them.
Who is to blame?
Everybody! From the home buyers who could only afford a $300,000 home and yet used one of the gimmick loans to buy a half-a-million dollar home; to the bankers and mortgage firms that created these loan schemes; to the banks and brokers that violated the rule of not having too many eggs in one basket; to the credit agencies that rated high risk mortgages portfolios as investment grade; to the politicians that insist on social experiments in the market place, refused any attempt at reform and their rigid accounting rules without any foresight.
How do we fix it?
First- suspend the mark to market rule and replace it with something more flexible. This would help clean up troubled companies’ balance sheets and buy them some time. Allow all the homeowners that actually want and have the means to pay to refinance their loans at cost and with a monthly payment they can afford. The rest of the troubled real estate is to be foreclosed immediately and put into a pool. The lenders would get ½ of the current market value and the private sector can buy shares of this pool. Any and all profits from this investment would be tax-free for life. This would raise billions of dollars and slow down the fall in home prices and protect the taxpayers’ pocket book. Stop legislating experimental social policies into the market place and insist on documentation to prove people can actually afford what it is they are buying. Finally, stop rewarding bad decisions and let poorly managed companies fail.
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